Many investors look to buy and sell stocks based solely on near-term business conditions. If management raises guidance for the next quarter, shares rally. And if management takes note of some near-term headwinds, investors flee.
A great example: Shares of insurance giant American International Group (NYSE: AIG) fell 6.5% on the day of its earnings release in late October when CEO Robert Benmosche noted that the company's property and casualty insurance businesses were far healthier than a few years ago but still not generating the returns that they should.
Investors were also disappointed that a planned asset sale of its aircraft lease finance business may not happen. AIG could instead sell part of that business in an IPO and retain a majority stake.
As a result, shares have now fallen below their 100-day moving average for the first time this year. Yet there is a simple reason to expect AIG to resume its upward move. The upside from here: a 40% gain over the next 12 months, and a lot more than that down the road.
That reason: Shares still trade at a sharp discount to tangible book value. Over the past few years, this stock has posted a solid rebound as investors stopped focusing on its distressing performance during the financial crisis and started focus on its impressive balance sheet growth. Forget the third-quarter noise: As long as shares trade at a 40% discount to tangible book value, they are a compelling bargain.
Notably, book value would have risen even higher by now were it not for the fact that AIG is buying back stock. In the most recent quarter, AIG repurchased 4 million shares for $192 million. That's just the first leg of a broader $1 billion buyback plan announced Aug. 1.
It bears repeating my favorite investment notion: Any share buyback plan while a stock trades below book value is the single best move a company can make. That's because book value per share can be reduced at a very fast rate, as the numerator (market value) shrinks even faster than the denominator (tangible book value). In some respects, it would almost be beneficial for AIG's shares to stay down while the $1 billion buyback plan is underway -- the cheaper the stock, the greater the reductions in the share count.
In fact, AIG and share buybacks may become synonymous for many years to come, and again, it is because of book value. Merrill Lynch sees that figure rising to $77 a share by the end of 2015, far higher than the current $47 share price. Merrill's "buy" rating is easy to grasp: "We see AIG as a classic value idea given a sizable discounted valuation relative to peers, low expectations and sentiment on the shares... and we believe that a focused management team, greatly improved risk management, a global (property/casualty) platform and a diversified earnings stream provide the fuel for potential gains."
In an ideal world, AIG would simply focus all of its financial firepower on buybacks, right up until the shares trade at tangible book value. But as Benmosche noted earlier this year on CNBC, buybacks and dividends are both part of the plan. AIG currently plays a paltry $0.10 a share quarterly dividend, though that payout appears poised to rise smartly in coming years.
Pivoting back to Merrill Lynch's math, the firm thinks AIG would add roughly $5 a share in book value each year were it not for buybacks and dividends. To be sure, management may start slow and fully part with more of its annual free cash flow in a year or two. But a $5-a-share annual return to shareholders in the form of dividends and buybacks works out to an 11% total shareholder giveback, based on today's share price.
As investors start to focus on rising dividends and robust buybacks, look for shares to rally from a recent $47 into the $60s. As a reminder, tangible book value stands at $67 and continues to rise. Long term, the upside is much greater, as long as book value keeps on rising.
Risks to Consider: Insurers are always vulnerable to economic slumps as their massive balance sheet cash positions start to generate negative returns on their various investments.
Action to Take --> AIG is a far stronger company than it was a few years ago, and investors should use any pullbacks (such as those we've seen lately) as an opportunity to build positions in this long-term builder of book value.